EVALUATION OF PORTFOLIO PERFORMANCE

Composite Equity Portfolio Performance Measures

As late as the mid 1960s investors evaluated PM performance based solely on the rate of return. They were aware of risk, but didn't know how to measure it or adjust for it. Some investigators divided portfolios into similar risk classes (based upon a measure of risk such as the variance of return) and then compared the returns for alternative portfolios within the same risk class. We shall look at some measures of composite performance that combine risk and return levels into a single value. Treynor Portfolio Performance Measure A measurement of return on a portfolio in excess of what a riskless investment would have earned per unit of risk. It is calculated by taking the portfolio's rate of return, subtracting the return on the riskless investment (usually a Treasury bond), and dividing by the portfolio's beta. It is important to note that the Treynor performance measure does not account for the effect, if any, of active portfolio management. It is simply a measurement of actual returns. It is also called the return to volatility ratio.

This measure was developed by Jack Treynor in 1965. Treynor (helped developed CAPM) argues that, using the characteristic line, one can determine the relationship between a security and the market. Deviations from the characteristic line (unique returns) should cancel out if you have a fully diversified portfolio. Treynor's Composite Performance Measure: He was interested in a performance measure that would apply to ALL investors regardless of their risk preferences. He argued that investors would prefer a CML with a higher slope (as it would place them on a higher utility curve). The slope of this portfolio possibility line is:

A larger Ti value indicates a larger slope and a better portfolio for ALL INVESTORS REGARDLESS OF THEIR RISK PREFERENCES. The numerator represents the risk premium and the denominator represents the risk of the portfolio; thus the value, T, represents the portfolio's return per unit of systematic risk. All risk averse investors would want to maximize this value. The Treynor measure only measures systematic risk--it automatically assumes an adequately diversified portfolio. You can compare the T measures for different portfolios. The higher the T value, the better the portfolio performance. For instance, the T value for the market is:

One can achieve a negative T value if you achieve very poor performance or very good performance with low risk. For instance, if you had a positive beta portfolio but your return was less than that of the risk-free rate (which implies you weren't adequately diversified or that the market performed poorly) then you would have a (-) T value. If you have a negative beta portfolio and you earn a return higher than the risk-free rate, then you would have a high T-value. Negative T values can be confusing, thus you may be better off plotting the values on the SML or using the CAPM. Sharpe Portfolio Performance Measure This measure was developed in 1966. It is as follows:

It is VERY similar to Treynor's measure, except it uses the total risk of the portfolio rather than just the systematic risk. The Sharpe measure calculates the risk premium earned per unit of total risk. In theory, the S measure compares portfolios on the CML, whereas the T measure compares portfolios on the SML.

Treynor Measure vs. Sharpe Measure. The Sharpe measure evaluates the portfolio manager on the basis of both rate of return and diversification (as it considers total portfolio risk in the denominator). If we had a fully diversified portfolio, then both the Sharpe and Treynor measures should given us the same ranking. A poorly diversified portfolio could have a higher ranking under the Treynor measure than for the Sharpe measure. Jenson Portfolio Performance Measure This measure (as are all the previous measures) is based on the CAPM: We can express the expectations formula (the above formula) in terms of realized rates of return by adding an error term to reflect the difference between E(Rj) vs actual Rj:

By subtracting the risk free rate from both sides, we get:

Using this format, one would not expect an intercept in the regression. However, if we had superior portfolio managers who were actively seeking out undervalued securities, they

could earn a higher risk-adjusted return than those implied in the model. So, if we examined returns of superior portfolios, they would have a significant positive intercept. An inferior manager would have a significant negative intercept. A manager that was not clearly superior or inferior would have a statistically insignificant intercept. We would test the constant, or intercept, in the following regression:

This constant term would tell us how much of the return is attributable to the manager's ability to derive above-average returns adjusted for risk. Applying the Jenson Measure. This requires that you use a different risk-free rate for each time interval during the sample period. You must subtract the risk-free rate from the returns during each observation period rather than calculating the average return and average riskfree rate as in the Sharpe and Treynor measures. Also, the Jensen measure does not evaluate the ability of the portfolio manager to diversify, as it calculates risk premiums in terms of systematic risk (beta). For evaluating diversified portfolios (such a most mutual funds) this is probably adequate. Jensen finds that mutual fund returns are typically correlated with the market at rates above .90. Relationship among Portfolio Performance Measures For all three methods, if we are examining a well-diversified portfolio, the rankings should be similar. A rank correlation measure finds that there is about a 90% correlation among all three measures. Reilly recommends that all three measures. [In my opinion the Jensen measure is the most stringent. It is testing for statistical significance, whereas the other methods are not. The other methods are also examining average returns, whereas the Jensen measure uses actual returns during each observation period.] Factors that Affect Use of Performance Measures You need to judge a portfolio manager over a period of time, not just over one quarter or even one year. You need to examine the manager's performance during both rising and falling markets. There are also other problems associated with these measures: Measurement Problems: All of these measures are based on the CAPM. Thus, we need a real world proxy for the theoretical market portfolio. Analysts typically use the S&P500 Index as the proxy; however, it does not constitute a true market portfolio. It only includes common stocks trading on the NYSE. Roll, in his 1980/1981 papers, calls this benchmark error. We use the market portfolio to calculate the betas for the portfolios. Roll argues that if the proxy used for the market portfolio is inefficient, the betas calculated will be inappropriate. The true SML may actually have a higher (or lower) slope. Thus, if we plot a security that lies above the SML it could actually plot below the "true" SML. Global Investing: Incorporating global investments (with their lower coefficients of correlation) will surely move the efficient frontier to the left, thus providing diversification

benefits. It may also shift the efficient frontier upward (increasing returns). [However, we have no proxy to measure global markets.]

Decomposition of Risk-Adjusted Performance

Also known as "Fama Decomposition". Starting point:

Realized return of a portfolio r(P) = 8%, ex post market risk of the portfolio b(P) = 0.67, total ex post volatility v(P) = 15% Realized index return r(B) = 9%, benchmark volatility v(B) = 21%, riskfree rate rf = 2%

Expected portfolio return, given the portfolio's ex post market risk... r(b(P)) = rf + b(P)*[r(B)-rf] = 2% + 0.67*[9%-2%]= 6.7% ...where 0.67*[9%-2%]= 4.7% is the risk premium p(b(P))for incurring market risk b(p). The difference between the realized and the expected portfolio return is selectivity s(P)... s(P) = r(P) - r(b(P)) = 8% -6.7% = 1.3% Striving for selectivity usually means giving up some diversification, which will shot up in terms of additional total portfolio risk as measured by portfolio volatility. The Capital Market Line (CML) can be used to determine the portfolio return consummate with the portfolio's total risk, the so-called normal portfolio return r(v(P)). It is calculated as follows... r(v(P)) = rf + [r(B)-rf]*v(P)/v(B) = 2%+[9%-2%]*15%/21%=7% The difference between the normal return and expected portfolio return is the added return for diversification d(P)... d(P) = r(v(P)) - r(b(P)) = 7%-6.7%=0.3% Net selectivity of the portfolio ns(P) then becomes overall selectivity minus d(P) needed to compensate for the diversification risk... ns(P) = s(P) - d(P) = 1.3%-0.3% = 1% Since the diversification measure is always nonnegative, net selectivity will always be equal to or less equal than selectivity. The two will be equal if the portfolio is completely diversified (determination coefficient R^2 = 1).

Performance Attribution
Performance Attribution or Investment Performance Attribution is a set of techniques that performance analysts use to explain why a portfolio's performance differed from the benchmark. This difference between the portfolio return and the benchmark return is known as the active return. The active return is the component of a portfolio's performance that arises from the fact that the portfolio is actively managed. Different kinds of performance attribution provide different ways of explaining the active return. Attribution analysis attempts to distinguish which of the two factors of portfolio performance, superior stock selection or superior market timing, is the source of the portfolios overall performance. Specifically, this method compares the total return of the managers actual investment holdings with the return for a predetermined benchmark portfolio and decomposes the difference into a selection effect and an allocation effect. Consider a portfolio whose benchmark consists of 30% cash and 70% equities. The following table provides a consistent set of weights and returns for this example.

Portfoli Asset Stock Total Benchmar Portfoli Benchmar Interactio Sector o Allocatio Selectio Activ k Weight o Return k Return n Weight n n e Equitie 90% s Cash Total 10% 100% 70% 30% 100% 5.00% 1.00% 4.60% 3.00% 1.00% 2.40% 0.12% 0.28% 0.40% 1.40% 0.00% 1.40% 0.40% 0.00% 0.40% 1.92% 0.28% 2.20%

The portfolio performance was 4.60%, compared with a benchmark return of 2.40%. This leaves an active return of 2.20%. The task of performance attribution is to explain the decisions that the portfolio manager took to generate this 2.20% of value added. Under the most common paradigm for performance attribution, there are two different kinds of decision that the portfolio manager can make in an attempt to produce added value: 1. Asset Allocation: the manager might choose to allocate 90% of the assets into equities (leaving only 10% for cash), on the belief that equities will produce a higher return than cash. 2. Stock Selection: Especially within the equities sector, the manager may try to hold securities that will give a higher return than the overall equity benchmark. In the example, the securities selected by the equities manager produced an overall return of 5%, when the benchmark return for equities was only 3%. The attribution analysis dissects the value added into three components:

Asset allocation is the value added by under-weighting cash (0.28%), and overweighting equities (0.12%). The total value added by asset allocation was 0.40%. Stock selection is the value added by decisions within each sector of the portfolio. In this case, the superior stock selection in the equity sector added 1.40% to the portfolio's return. Interaction captures the value added that is not attributable solely to the asset allocation and stock selection decisions. In this particular case, there was 0.40% of value added from the combination that the portfolio was overweight equities, and the equities sector also outperformed its benchmark.

The three attribution terms (asset allocation, stock selection, and interaction) sum exactly to the active return without the need for any "fudge factors".

About Attribution Effects

In a return decomposition analysis model, value added to a portfolios return is commonly referred to as the active management effect. The active management effect is the difference between the total portfolio return and total benchmark return. It is also the sum of the following investment decisions or effects: Allocation Selection Interaction Defining the Allocation Effect The allocation effect measures an investment managers ability to effectively allocate their portfolios assets to various segments. A segment refers to assets or securities that are grouped within a certain classification such as Equity, Fixed, or Technology. The allocation effect determines whether the overweighting or underweighting of segments relative to a benchmark contributes positively or negatively to the overall portfolio return. Positive allocation occurs when the portfolio is overweighted in a segment that outperforms the benchmark and underweighted in a segment that underperforms the benchmark. Negative allocation occurs when the portfolio is overweighted in a segment that underperforms the benchmark and underweighted in a segment that outperforms the benchmark. Scenario 1 A positive allocation effect occurred because the portfolio weight was greater than the benchmark weight and the benchmark return was greater than the total benchmark return. The investment manager over allocated assets to a segment that outperformed the total benchmark. Scenario 2 A negative allocation effect occurred because the portfolio weight was greater than the benchmark weight and the benchmark return was less than the total benchmark return. The investment manager overallocated assets to a segment that underperformed the total benchmark. Scenario 3 A negative allocation effect occurred because the portfolio weight was less than the benchmark weight and the benchmark return was greater than the total benchmark return. The investment manager underallocated assets to a segment that outperformed the total benchmark. Scenario 4 A positive allocation effect occurred because the portfolio weight was less than the benchmark weight and the benchmark return was less than the total benchmark return. The investment manager underallocated assets to a segment that underperformed the benchmark.

Defining the Selection Effect The selection effect measures the investment managers ability to select securities within a given segment relative to a benchmark. The over or underperformance of the portfolio is weighted by the benchmark weight, therefore, selection is not affected by the managers allocation to the segment. The weight of the segment in the portfolio determines the size of the effectthe larger the segment, the larger the effect is, positive or negative. Scenario 1 A positive selection effect occurred because the portfolio return was greater than the benchmark return. The investment manager made good decisions in selecting securities that, as a whole, outperformed similar securities in the benchmark. Scenario 2 A negative selection effect occurred because the portfolio return was less than the benchmark return. The investment manager made poor decisions in selecting securities that, as a whole, underperformed similar securities in the benchmark.

Treynor Portfolio Performance Measure of my portfolio Here